Annual Percentage Yield (APY)

By JAMES CHEN
 Updated Aug 31, 2019
What Is the Annual Percentage Yield (APY)?
The annual percentage yield (APY) is the real rate of return earned on a savings
deposit or investment taking into account the effect of compounding interest.

Unlike simple interest, compounding interest is calculated periodically and the

amount is immediately added to the balance. With each period going forward, the
account balance gets a little bigger, so the interest paid on the balance gets bigger as
well.

KEY TAKEAWAYS

 APY is the actual rate of return that will be earned in one year if the interest is compounded.
 Compound interest is added periodically to the total invested, increasing the balance. That
means each interest payment will be larger, based on the higher balance.
 The more often interest is compounded, the better the return will be.
Banks in the U.S. are required to include the APR when they advertise their interest-
bearing accounts. That tells potential customers exactly how much money a deposit
will earn if it is deposited for 12 months.

Formula and Calculation of APY

APY is calculated by:

In this APY formula, 1 is the amount deposited. So, if you deposited $100 for one
year at 5% interest and your deposit was compounded quarterly, at the end of the year
you would have $105.09. If you had been paid simple interest, you would have had
$105.

That's not too dramatic. But if you left that $100 in the bank to continue compounding
interest for four years, you would have $121.99. With simple interest, it would have
been $120.

What APY Can Tell You

Any investment is ultimately judged by its rate of return, whether it's a certificate of
deposit, a share of stock, or a government bond. The rate of return is simply the
percentage of growth in an investment over a specific period of time, usually one
year.

But rates of return can be difficult to compare across different investments if they
have different compounding periods. One may compound daily while another
compounds quarterly or biannually.

Standardizing the Rate of Return

Comparing rates of return by simply stating the percentage value of each over one
year gives an inaccurate result, as it ignores the effects of compounding interest. And,
it is critical to know how often that compounding occurs. The more often a deposit
compounds, the faster the investment grows, since every time it compounds the
interest earned over that period is added to the principal balance and future interest
payments are calculated on that larger principal amount.

APY standardizes the rate of return. It does this by stating the real percentage of
growth that will be earned in compound interest assuming that the money is deposited
for one year.

Therefore, in the example above, the $100 deposit is in an account that pays the
equivalent of 5.09% interest. It pays 5% a year interest compounded quarterly, and
that adds up to 5.09%.

Comparing the APY on Two Investments

Suppose you are considering whether to invest in a one-year zero-coupon bond that
pays 6% upon maturity or a high-yield money market account that pays 0.5% per
month with monthly compounding.

 
Comparing two investments by their interest rates doesn't work as it ignores the
effects of compounding interest and how often that compounding occurs.

At first glance, the yields appear equal because 12 months multiplied by 0.5% equals
6%. However, when the effects of compounding are included by calculating the APY,
the money market investment actually yields 6.17%, as (1 + .005)^12 - 1 = 0.0617.

APY versus APR

APY is similar to the annual percentage rate (APR) used for loans. The APR reflects
the effective percentage that the borrower will pay over a year in interest and fees for
the loan.

APY and APR are both standardized measures of interest rates expressed as an
annualized percentage rate.

However, the equation for APY does not incorporate account fees, only compounding
periods. That's an important consideration for an investor, who must consider any fees
that will be subtracted from an investment's overall return.

Related Terms

What the Annual Percentage Rate (APR) Tells You

An APR is defined as the annual rate charged for borrowing, expressed as
a single percentage number that represents the actual yearly cost over the
term of a loan.
 more
Interest Rate: What the Lender Gets Paid for the Use of Assets
The interest rate is the amount charged, expressed as a percentage of the
principal, by a lender to a borrower for the use of assets.
 more
Compound Interest
Compound interest is the number that is calculated on the initial principal
and the accumulated interest from previous periods on a deposit or loan.
 more
Determining the Annual Equivalent Rate (AER)
The annual equivalent rate (AER) is the interest rate for a savings account
or investment product that has more than one compounding period.
 more
What the Effective Annual Interest Rate Tells Us
The effective annual interest rate is the real return on an investment,
accounting for the effect of compounding over a given period of time.
 more
What Does Nominal Mean and How Does it Compare to Real Rates
Nominal is a common financial term with several different contexts,
referring to something small, an unadjusted rate, or the face value of an
asset.
 more